Wednesday, March 27, 2013

I find it hard to get excited by carmakers, even with the motor shows season going on. European producers' woes and the gloomy guidance they're giving after years of negative growth is one reason. Another one is the fading momentum in the US after three years of pent up demand and a full industry overhaul. Overlooking the sector would however be a mistake with the current consensus centering on a 3% to 6% increase in global auto sales for 2013. Not bad and above the 3% world GDP growth forecast of the World Bank.

With the European car market most probably continuing its downtrend in search of a bottom and the US losing pace, a reasonable conclusion is that something is at works in some other region. It appears that the variable balancing out the equation is, not a real surprise, Asia-Pacific:

New car sales in Asia rose 10% through 3Q, compared with 0.1% growth for the same nine-month period in 2011. Consensus real GDP forecasts in Asia call for 6.8% growth in 2013, the highest of any region, and 6.9% in 2014. Economic expansion at these levels is conducive to wealth creation and new car demand growth - Bloomberg

I did not perform a top-down macro analysis to uncover those facts. I started looking at the auto industry story because Hyundai Motor Company (HMC) caught my attention while I was screening stocks in emerging markets and Asia. It turns out that in addition to nice valuations metrics and appealing financial ratios, the company is well positioned to ride supportive market dynamics in its home region and beyond.

The company

HMC, together with his affiliate Kia (36% stake), belongs to the top 5 car producers worldwide with a 5% global market share. This South Korean chaebol benefits from a strong domestic franchise and is ideally located in the in the buoyant Asian region that makes up 44% of their volumes. Western countries are also important, but less so, with the US and Europe representing 16% and 11% of their order book respectively (2011).The company offers all types of vehicles from city cars to SUVs and sedans. A lean business model, competitive pricing and the attractiveness of their cars re-designed by the former Audi/VW wizard Peter Schreyer, have enabled them to gain market shares from other players in key markets they serve over the past few years. In H2 2012 for example, Hyundai and Kia were the only brands gaining pace in Europe (+12% and +24%) while German, French, US and Japanese competitors suffered declining demand ranging from -1% for BMW to -17% for Fiat and Renault.In the second half of 2012, the situation got more difficult. Like any Korean producer, Hyundai faced stiff headwinds from a strengthening Korean Won (+8% vs. USD and +11% vs. JPY for the whole of 2012). These forex movements eroded their competitiveness at home and abroad and lowered the profits recorded from overseas operations. On top of those currency swings, claims about Kia's advertised mileage consumption in the US cost the company USD 220m to settle and caused a sharp drop in Q4 2012 profits. So here we are; the stock suffered for the most of 2012 and is now attractively valued. More favorable FX trends and good execution on a business strategy focused on increased profitability should be triggers for re-rating. The following are some pros and cons to the investment case.

Pros and Cons

(+) Good valuation With a PE 2013 estimated at 6.12, the stock is at a discount to its global peers (Volkswagen 6.83, GM 8.63, BMW 8.75, Fiat 10.12...)

(+) Sound balance sheet with a Debt/Capital ratio of 7.5% vs. the global industry average high above at 43%. And that's without considering cash and other short-term investments that amount to 24% of their balance sheet. Solid war chest I'd say.

(+) Efficiency In the beginning of March, Hyundai and Kia demonstrated their flexibility by digesting weekday working hours reduction from 20 to 17 in their South Korean factories. They just boosted units production per hour by 8%, swiftly. Globally, they run with the lowest inventory level at 3% of their assets when other first class players like BMW and GM are at 7.4% and 9.8% respectively.

(+) Growth Hyundai and Kia have had above average sales growth over the past 5 years at 7% and 12% respectively. Further avenues for expansion are tackled by establishing a strategy to be better positioned on the fleet market and through a global strategic alliance with Santander to compete on the financing side with groups that have their in-house banks like VW, BMW, GM,...

(+) Profitability 10% operating margins, slightly above BMW despite lower priced cars. The current strategy of HMC is to further improve this figure by shifting to a more profitable product mix tilted to mid and large-size sedans and SUVs and lowering incentives and marketing costs.

(-) Corporate governance Family-led South Korean conglomerates, or chaebol, are not particularly famous for fair handling of minority shareholders. Dividend policies, strategic alliances, M&A decisions, etc. have not always been very transparent. The Korean discount is as a consequence around 20% in average to Asian peers.

(-) Exchange rates The aggressive monetary policy engineered by the Bank of Japan has massively weakened the Yen and favored Japanese car producers like Toyota and Honda in in the big next-door market, China. This trend already caused a big drop in fourth quarter profits and could still go on for a while.

(-) Slow model cycle and lack of new products to create the buzz and support sales in 2013

(-) Capacity constraint in the US last year impacted HMC that grew at a slower pace than the industry. That's a 'good' problem to have but it needs to be addressed

Conclusion

Overall, the risks are outweighed by the opportunities for HMC. I like what I've seen and read about this company and will definitely keep an eye on it. Fundamentals, market evolutions, current stock price behavior and the support level around KRW 200k make it a buy, in my view.

Monday, March 11, 2013

Michael, who already contributed on this blog (I strongly recommend his post on value investing available here), took a close look at the European Smaller Companies screen and has made some research on a stock he found appealing. Here it is.

Enjoy the read, don't hesitate to comment and share if you like it!

Regards,

Pierre

As a value investor, the European smaller companies screen provides me with a great hunting ground (check the screen here).

One company that caught my attention is Danieli, the Italian steel specialist.Italy? Steel? No wonder the company is cheap. This must be a value trap, right?Well, let’s check it out.Danieli’s origins date back to 1914, when 2 Danieli brothers started a company in Brescia in Northern Italy to use Electric Arc Furnaces in steelmaking. In 1955 Luigi Danieli took over the family business (50 people) and started designing and manufacturing equipment for the steel industry, maximizing the use of automation. The first minimill was installed in Germany in 1964, and spread to Spain, the US and Asia. The company accelerated its growth under the leadership of Cecilia Danieli and her partner Gianpietro Benedetti (the current CEO). Following large investments in research, and M&A activity around the world, Danieli ranks today among the 3 largest suppliers of plants and equipment to the global metals industry (after Siemens VAE and SMS).

The company is still 63% controlled by the Danieli-Benedetti family and has 2 businesses:

Plantmaking (~70% of revenues). This is a high margin, high return business. It is driven by the need of more steel capacity in emerging markets. The plantmaking market is characterized by its oligpopolistic nature (the top 3 companies have a 60% market share), high barrier to entry and good pricing power thanks to its diversified client base (ie. steelmkaers such as Posco, Tata Steel). Danieli is a global player with facilities in China, India, Russia, Thailand, Vietnam, amongst others, and over 75% of sales in emerging markets. It has a flexible cost base with fixed costs representing around 10% of total costs.

Steelmaking (~30% of revenues). Specialty steel manufacturing business (ABS - Acciaierie Bertoli Safau) making high quality steel for the Italian, German, Austrian construction and engineering sector. Danieli has made significant investment to restructure the business. Stelmaking was loss-making until 2004, and again in 2009-2010, but generated an EBITDA of €112m in 2012; it is currently undergoing a difficult phase. Danieli bought a plant in Croatia (not far from the Italian headquarters) in 2012 to reinforce this business.

Below are the company’s key figures in EURm (the financial year ends in June):

The business has been growing very strongly until 2008 (CAGR > 20%) and has stabilized since then. Note that the order book excludes a €600m contract in Ethiopia and the pipeline looks promising (e.g., Egypt, Abu Dhabi).

Profitability has increased, with an EBITDA margin > 10% (despite headwinds from projects in Egypt and Libya resulting from the Arab spring).

Return on equity remains high, above 10%.

The company is very cash-rich, which is important given its cyclicality. Around €500m of cash come from client prepayments.

So we’re talking about a profitable business with a long track record and strong balance sheet, well-positioned to capture the growth in global infrastructure. A closer look at valuation indicators confirms that the stock is cheap on all metrics. To illustrate the point, Danieli trades at only 3 times Enterprise Value (EV) on EBITDA (twice less than similar companies).

The company’s savings shares pay a slightly higher dividend than the voting shares (35 cents vs. 33 cents). They currently trade at a 35% discount compared to the voting shares, in line with the historical discount.

Concluding thoughts:

The fundamental value of Danieli is significantly higher than its current market price. The share price has come off recent lows (the voting shares traded at €15 during the height of the European debt crisis; I wish I had looked at the company at that time) but still offers good value.

It seems that Mr. Market heavily penalizes the company because of its cyclicality, Italian roots, complex share structure.

Some analysts view the potential award of large contracts as a catalyst. At current valuations and with a long-term investment horizon, I believe there is a sufficient margin of safety even without major contract wins.

Disclaimer 1: I have just bought shares of Danieli. "Put your money where you mouth is", right?Disclaimer 2: I am working for a Private Bank in Belgium. The views expressed here are mine and not those of my employer.

Wednesday, March 6, 2013

Italian voters made it clear last week that there is no straight way out of the European mess. Markets corrected strongly and fear was back with peripheral bond yields and equity volatility picking up. Things have normalized since then but this type of event could well occur again in the near future and offer opportunities for stock pickers. In this second part of the "Hunting for European Smaller Companies" series (first part accessible here), we will take a deep dive and screen stocks in search for gems that could be offered at a discount due to market turbulences. An Excel file is attached at the end of the post with the list of stocks that passed the test.

Screening process

The universe we defined previously consisted of Russell Developed Europe Index constituents with a market capitalization below € 7.5 billions. This is a set of 1624 companies. As we do not have an army of analysts working on this blog, we will first have to use quantitative criteria to set aside the names that are unlikely to be good candidates for investment.I have looked at the whole universe (smaller and larger caps combined) and concentrated on 6 key measures; 621 smaller caps and 62 larger ones that did not have data on one of those six axis were thrown away. I will call the 1206 stocks that remained the "workable index". In this workable index, quartiles were defined for all ratios. Smaller stocks belonging to the worst quartile on any of the dimensions studied or that did not score well with respect to an arbitrary level were dismissed. Below are the details.

Price multiples

The goal here is to gauge how much we are paying for one unit of money produced or booked somewhere on the firm's financial statement. If a company's earnings power and future expected cash flows (which are supposed to be captured in the share price) are comparatively higher, you will be ready to pay comparatively more for one unit of its assets, cash flows, earnings, etc. Higher multiples mean less margins of safety for buyers if reality doesn't meet expectations.

Price to book (PB) First things first. I like the ratio because it is relatively stable and intuitive. With a value greater than one, you would lose money if the company went immediately bankrupt as assets sales would not compensate for the price you paid. Lower than one doesn't mean bargain, there could be good reasons like overvalued intangible assets, unrecognized impaired ones or poor business outlook.

The highest quartile begins at 3.19 in our workable index, the 242 smaller companies with a ratio beyond that limit were disqualified here. This still leaves us with some quite expensive stuff.

Price to Earnings (PE) The star measure. It tells you, among other things, how many years would be required to produce earnings that would equal the price you paid. The problem with the PE is that it is a volatile indicator, I would prefer to use Price-to-5-years-average-earnings-before-extraordinary-items but this was not readily available so I will stick to the good-old trailing 12 months proxy.

The the fourth quartile begins at 23.14, filtering out 164 names.

Free Cash Flow Yield (FCF/P) Cash is king. Free cash flow cleans net income from easy to manipulate non-cash items like depreciation and amortization and gives a fairer picture of profitability after the company has paid for operating expenses. A big difference with EBITDA or Cash From Operations is that Free Cash Flow deducts capital expenditures from Net Income. Capex are necessary to maintain/grow the assets base and can absorb a substantial part of the revenues in some industries. The level of cash is calculated before interest/dividend payments so we can use the ratio to compare companies with different capital structures. The higher the ratio, the cheaper it is to buy the money machine.

We set the limit at 4.16%, the median of the workable index, below is too low. 276 stocks are out.

Other multiples

Net Debt/Equity Leverage is a good way of enhancing returns to shareholders, too much of it can be dangerous and put the company at risk. Net debt subtracts the cash from short term and long term liabilities, as it could be used to pay back creditors if necessary. I often complement this measure with the interest coverage ratio that tells me how many times the company can pay for debt servicing from EBIT. This gives more insight than leverage in absolute terms.

70% is our top quartile frontier here, I prefer setting the limit at 100% and check the financial structure in more details later. We get rid of 48 additional stocks.

Operating Income/Net Sales A.k.a. Operating Margin, it reveals the portion of revenues that is left after the company has paid for the variable costs of production. On top of giving a profitability measure, a high and resilient figure can indicate that a company has a unique technology, brand name or other barrier to entry that prevents competition to enter its market. Low margins can be an indication of a mature business, nothing to be afraid of if this goes with good volumes, strong market position or reasonable valuation.

Return on Equity (ROE) ROE is one of the many return ratios available. As we already look at leverage and cash position with Net Debt/Total Capital, we can overlook ROIC at this stage. ROE is simply the Net Income/Shareholder's Equity.

Results

We end up with 181 smaller cap stocks, an Excel file giving you an overview of the results can be downloaded here. These names need to be followed, monitored and further analyzed; we'll come back on them in future posts.As a bonus, you will find a sheet containing the bigger caps that qualified along all criteria. They are of course worth considering too.That's all for this time, see you around soon.Pierre